The Invisible Stock Bubble

Prices seem normal next to earnings, but history says earnings might plunge.

By

JackHough

Asset bubbles typically form because of widespread denial, not a lack of obvious signs. In 2000, just before the dotcom stock crash, the S&P 500 index of large American companies traded near 30 times trailing earnings, about double its historic average, but the Internet, some said then, had made price-to-earnings ratios obsolete. In early 2007, before a 30% drop in U.S. house prices, the ratio of prices to rents was twice normal levels, but generous financing and subsidies had supposedly redefined affordability.

A new stock bubble might now be in the making, but this time the signs are less obvious. U.S. stocks, despite having racked up a decade worth of typical gains in the 26 months after their recessionary low, do not look expensive. The S&P 500 trades at 15.3 times trailing earnings, only a smidgen above its historic average of 14.5.

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Those numbers might be luring investors toward a cliff, however. History suggests today's corporate earnings are unsustainably high relative to the size of the economy. The real price-to-earnings ratio, based on a more normal level of earnings, is well over 20.

To see why, consider a broad measure of America's prosperity called national income. It consists of corporate profits, worker wages, sole proprietor income and more. Corporations and workers compete against each other for income but also rely on each other for success. When profits and wages grow in tandem, the result is healthy economic expansion. When one grabs too large a slice of the nation's income pie, it usually signals a downturn waiting to happen.

For example, corporations since 1929 have collected an average of 6.4 cents per dollar of national income as after-tax profits. In 1966 corporate profits swelled to 8.3 cents per dollar of national income; they then fell 19% by the end of the decade. In 1997 they were 8.6 cents per dollar of national income; by the end of that decade they were down 13%.

Workers, after all, are customers. If they're not participating in the boom, then the boom might be a bubble.

Last year corporate profits reached 9.4 cents per dollar of national income. That's 47% too high by historic standards. If earnings were to shrink to their historic average, the aforementioned P-E ratio of 15.3 for the broad stock market would rise to nearly 23. The result would almost surely be a plunge in share prices.

Yale economist Robert Shiller uses a different method to detect exaggerated earnings. He calculates P-E ratios based on 10 years of earnings, just in case past-year earnings are unrealistically rich. His math puts U.S. stocks at 24 times earnings. In late 2007 at the market's peak they were 27 times earnings.

There are three possible outcomes to the current profit boom:

1. It lasts forever as a "new normal." That seems unlikely. Perhaps the benefits of global trade have flowed mostly to corporations and foreign markets, but both will have fewer customers if the benefits don't soon reach U.S. workers. Maybe the financial sector, which creates outsized profits with relatively few workers, has become a permanently larger part of the economy -- but without a sufficient wage base there will be less consumer demand for the financial wizardry behind mortgages, insurance, credit cards and more.

2. Wages or hiring soar. David Rosenberg, chief economist at investment boutique Gluskin Sheff, notes that the U.S. has the greatest amount of slack in its labor market ever for an economy about to celebrate its second year of expansion. Perhaps it's due for a hiring spree. Two signs give pause, however. First, although history suggests worker wages are now 10% too low relative to national income, total compensation, including benefits, is normal. Higher healthcare costs have taken a bite out of pay that might not be returned. Second, the ratio of government workers to manufacturing workers is at a historic high, and the state of public budgets is such that government layoffs seem likely.

3. Stock investors should look out below. Corporate profits have commanded this large a share of national income only twice before: in 1929 and 2006. Those years preceded the past century's worst two financial collapses.

Jack Hough is an associate editor at SmartMoney.com and author of "Your Next Great Stock."

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